Selecting the Right Entity Structure Requires Asking the Right Questions

Every entrepreneur faces the same task when starting a new business: determining which entity structure will be best for the enterprise. Sometimes the answer is simple. Other times, it is not.

Unfortunately, “simple” is not always as simple as it seems. Going on a legal website and paying for documents that establish your corporation, then paying extra to make an S corporation election, seems simple. But more often than not, these documents are inadequate. Selecting the correct entity should result from a detailed examination of what your business will look like and its long-range plans.

The choice of entity selection should begin with a discussion between you and a trusted advisor, typically your accountant or a lawyer, focusing on several key questions. For instance:

• Will you be the sole owner, or will you have partners?
• What type of product or service will you sell?
• How much income do you anticipate?
• Will you be selling your products or services in multiple states? Internationally?
• Do you plan to go public eventually?
• What are your primary risk factors, and how might they change?

Each entity type is characterized by advantages and disadvantages that depend on the answers to the above questions.

Perhaps your best friend started a business buying, renovating and flipping houses and is doing quite well. You want to start a similar business, but you and your spouse will be partners. Eventually, you plan to add a construction component to your business, rather than contracting it out. Your needs in terms of entity type are very different than your friend’s.

Entity Types

The choice of entity comes down to these main types:

• Sole proprietorship
• Limited Liability Company (single member or multi-member)
• General partnership (more than one member)
• Corporation – (C corporation or S corporation)
• Trust (typically used only by real estate businesses)

Going for the Right Fit

The first step is to assess what your business will look like and what your needs as an owner will be, then match up your needs with the entity structure that addresses them fully.

For an entrepreneur with a for-profit trade or business that sells goods or services, works alone, and has little to no liability, starting as a sole proprietor is the simplest and least expensive route. Other than filing a DBA (Doing Business As) form to establish your business name and obtaining an Employer Identification Number (EIN) from the IRS, there is nothing to do and no additional cost.

Once your sales top $100,000, though, it’s time for more formalization. Sole proprietors with more than $100,000 in sales tend to draw audit attention from the IRS, and there’s no sense in waiting around for that.

Additionally, once you have grown, you may have hired one or two employees. That leads to the next consideration in the search for the right entity type — risk. Once you have employees, your business needs protection from risk. An employee may be injured on the job or make a production mistake that results in a customer lawsuit.

LLC Advantages

With higher revenues and employees, it may be time to step up to an LLC structure or some type of corporate structure that will provide the kind of legal protection you need. The first entity type to consider would likely be an LLC, which has multiple advantages for a growing company, including:

• Protection of owner’s personal assets from litigation and creditors
• Tax benefits
• Limited personal liability for owner

Liability protection is one of the biggest advantages of moving from a sole proprietorship to an LLC. An LLC also offers flexibility in how it’s taxed. It can be treated as a disregarded entity (if there’s only one owner), a partnership, an S corporation, or a C corporation. If the sole proprietor plans to bring in investors or partners, continuing as a sole proprietorship is no longer an option, and an LLC becomes a practical next step.

Additionally, an LLC tends to offer greater credibility, improved access to business credit, and eligibility for certain tax benefits, such as California’s Pass-Through Entity (PTE) Tax program, which are not available to sole proprietorships but are accessible to LLCs taxed as S corporations or partnerships.

If a business has real estate investments that it will hold for the long term and has unrelated tenants in the buildings, the owner needs strong liability protection, which an LLC provides. Generally, we avoid holding real estate directly under an S corporation because transferring appreciated property into or out of an S corporation typically results in an immediate taxable gain. The IRS treats it as a deemed sale at fair market value, which triggers recognition of gain, even if there’s no actual economic sale.

Partnerships can distribute appreciated property to partners without recognizing gain, unlike S corporations. Pairing this structure with cost segregation strategies can generate substantial depreciation up front. The S corporation operating business can then lease the property from the LLC and deduct the rent payments, reducing its ordinary income.

Owners of real estate are often advised to form a separate LLC for each individual piece of real estate for maximum risk management. This is particularly true if you own apartment buildings. However, that can be costly, especially in California, where an annual $800 fee is required for every LLC. If you are renting multiple real estate units to your own business, the risk is relatively low, and these can be grouped into a single LLC.

Corporation Structure

An owner who wants to limit the amount of payroll taxes they are paying for their own salary should consider a corporate entity, either a C corporation or an S corporation. That way, the owner can set up a W-2 form and set their salary at a reasonable level (the IRS pays attention to “reasonableness”), thereby saving the 15% employment taxes on any income above the salary level, which would generally be taken as an annual distribution.

The decision of whether the entity should be a C or an S corporation ultimately depends on whether the owners intend to have different classes of shareholders. If the plan is to pay a preferred dividend rate to one shareholder class, your entity must be a C corporation. S corporations can only have one class of stock.

A C corporation comes with one significant disadvantage. An owner will be paying both their personal federal income tax and corporate income tax, which can be as high as 21%. By making an S election, the corporation can remain a pass-through entity, avoiding federal taxes at the corporate level and taking advantage of possibly a reduced tax rate for qualifying businesses at the individual level.

The C corporation entity structure is the preferred choice for companies that intend to go public. However, an S corporation or LLC can switch to a C corporation right before an initial public offering.

Implications for Multi-state Companies

Companies operating in multiple states, even if it’s just two states, have special tax considerations that drive entity selection.

Suppose you are a 100% owner of a corporation based in California, and you operate and earn revenue outside of California, with an S corporation structure. In that case, every dollar of income will be taxed in California, subject to California’s high income tax rates because you’re a resident of the state.

But say you have operations in Arizona and Texas, as well as California, where you are a resident. If you have a C corporation structure, you can apportion your income depending on the percentage earned in each state and pay taxes to Arizona and Texas at their rates. This would lower your California taxes because you would only pay taxes on the apportioned California income.

Now that 100% bonus depreciation has been made permanent, the S corporation structure offers another significant tax advantage for its owners. If you purchased equipment, the 100% bonus depreciation is reported on your personal tax return, as an S corporation is a pass-through entity. Otherwise, if your company is a C corporation, those expenses are trapped inside the corporation.

Summary

The selection of the right entity structure for your business requires examining not only the ownership structure, the goods and services to be sold, and the company’s risk profile, but also a myriad of possible twists and turns that may occur down the road. Moreover, it requires a realistic assessment of currently unforeseen opportunities or threats that may arise.

We’re here to help

If you have questions about which entity selection would be best for your new business or whether it’s time to change the entity selection for your existing business, we can help. Contact your JLK Rosenberger team member, or click here to contact us. We look forward to speaking with you soon.